How Escrow Accounts Work in Homebuying and Mortgages

Buying a home comes with a lot of new financial terms, and one of the most common is an escrow account.

If you’ve looked at a mortgage estimate or breakdown of your monthly payment, you’ll see that a portion of what you pay is allocated to funding an escrow account. Many first-time homebuyers wonder where that money goes and why the lender collects it.

An escrow account helps ensure your homeownership expenses are paid on time. During both the home-buying process and the life of your mortgage, escrow acts as a financial safeguard so that you don’t fall behind on important obligations, such as your homeowner’s insurance and property taxes.

Discover the answers to your questions like “How does an escrow account work?”

What is an escrow account?

An escrow account is a separate account that temporarily holds money for a specific purpose until certain conditions are met. You’ll typically encounter an escrow account in two situations:

• During the purchase of a home
• After closing, to pay ongoing property-related expenses

An independent third party, known as an escrow agent or escrow company, manages the funds during the home purchase. After you close on your home, your mortgage servicer typically manages your mortgage escrow account. The servicer will pay annual obligations like your property taxes and homeowner’s insurance premiums.

How does an escrow account work?

What is an escrow account, how does it work, and when is it used? Your escrow account will function differently depending on where you are in the home-buying process. Before closing, escrow protects both the buyer and seller by holding funds until all conditions of the sale have been satisfied.

After closing, your mortgage lender will collect a portion of your annual property taxes and homeowners' insurance premiums with each monthly mortgage payment. Instead of paying these large bills yourself in a lump sum, your lender deposits the money into an escrow account and pays them on your behalf.

Escrow during a home purchase

The pre-purchase escrow is typically created when everyone signs a purchase agreement. If you are buying a home, you’ll typically make an earnest money deposit (EMD), which is placed into an escrow account to demonstrate that you’re serious about following through. The escrow company holds the money until closing.

The purchase agreement will usually include an inspection period and several provisions that allow you to lawfully cancel the contract. If you cancel the contract for a permissible reason, such as a failed inspection, you will receive a refund. However, if you cancel the contract outside of those conditions, you could forfeit your EMD.

During this period, several important steps usually occur, including:

• Home inspections
• Property appraisal
• Title search
• Loan approval
• Final review of purchase documents

Once every condition outlined in the contract has been met, you can progress to closing. At that point, your EMD will be applied to your down payment or closing cost obligations.

Escrow after closing (mortgage escrow)

Once you’ve purchased the home, you’ll be dealing with a different type of escrow account. Typically, part of your closing costs will be used to fund the initial escrow account. Many mortgage lenders require you to maintain an escrow account throughout the life of the loan, especially if you are putting less than 20% down.

Each month, your mortgage payment may include:

• Principal
• Interest
• Property taxes
• Homeowners insurance
• Mortgage insurance (if required)

The lender deposits the tax and insurance portions of your monthly payment into the escrow account. When those bills are due, the lender will use the money in your escrow account to pay them. This system protects you and the lender by making sure your property is properly insured and that you are paying applicable taxes.

What payments does an escrow account cover?

The exact expenses that your lender covers with an escrow account will vary depending on your mortgage and where you live. Typically, escrow payments include:

• Property taxes
• Homeowners insurance premiums
• Private mortgage insurance (PMI)
• Flood insurance, when required

Take a look at your monthly mortgage statement for a breakdown of where your money is going. Most of your money will go toward the principal and interest. A smaller portion of your payment will be used to fund the escrow account.

How escrow payments are calculated

The lender will estimate your annual escrow expenses using the current tax bill, insurance premiums, and any required mortgage insurance. They will then divide that amount by 12 to determine your monthly escrow contribution.

Imagine your estimated annual expenses include $3,600 in property taxes and $2,400 in homeowners' insurance. That’s a total of $6,000, which results in a monthly escrow payment of $500.

What happens if your escrow account has a shortage or surplus?

If your account has a surplus, your lender will typically refund the excess amount. If your escrow is going to experience a shortage, the lender will cover the difference on your homeowner’s premium and property taxes.

The lender will adjust your escrow contributions based on the new costs. You will also be charged extra on your mortgage payment until you repay the money that they fronted you.

If you don’t want to spread out the shortage over future monthly payments, you can make a lump-sum payment to your lender.

Pros and cons of an escrow account

There are benefits and potential drawbacks to an escrow account. The pros include:

• Simplifying budgeting by spreading large annual expenses across monthly payments
• Helping prevent missed property tax or insurance payments
• Reducing the risk of tax liens
• Providing convenience because your lender handles payments

The drawbacks can include:

• Annual escrow adjustments causing payment changes
• Less control over when funds are paid
• Increasing your monthly mortgage payment

For most homeowners, the built-in security and convenience of an escrow account can give peace of mind.

How does an escrow account work? Understanding the answer makes a big difference

During a home purchase, an escrow account safely holds your deposit until the deal is finalized. After you buy a home, your lender uses an escrow account to cover essential home-related expenses. Dealing with escrow accounts is simply part of buying a home.

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